Dealpolitik: Goldman, Self-Inflicted Wounds and a Bit of Naiveté

Goldman Sachs is getting hammered in these pages (including by me) and in other financial news outlets as a result of how it handled its conflicts in advising El Paso on Kinder Morgan’s takeover.

The facts in Chancellor Strine’s opinion last week on the subject are indeed stunning. Goldman has a $4 billion investment in Kinder Morgan—the buyer– but found itself advising El Paso—the seller. Strine laid out a case that although Goldman disclosed its conflicts to El Paso and tried to manage them, it had been ineffective in doing so.

The lead banker personally owned $340,000 in Kinder Morgan stock, knowledge of which never seemed to have made it to the El Paso board. And although Goldman (which was initially working on another transaction for El Paso when Kinder Morgan approached El Paso) at first stepped aside from the Kinder Morgan deal, it apparently ended up being involved and will be collecting a $20 million fee if the Kinder Morgan deal closes. Finally, Morgan Stanley, which was brought in to cleanse the whole situation, receives a fee if, but only if Kinder Morgan acquires El Paso, leaving both financial advisers with significant financial interests in seeing the Kinder Morgan deal close.

Bloomberg News

Nevertheless, some of the moral outrage over this is a bit naïve. Investment bankers are neither Solomon-like judges nor lawyers who have explicit rules on conflicts of interest (and who sometimes have their own problems navigating conflicts). Investment bankers are business men and women. In short—and there is no dispute about this—they are in it for the bucks.

Bankers always have conflicts. For example, they almost always earn a big fee if a client does a deal and earn nothing or a nominal fee if there is no deal. Sometimes they earn a fee for keeping a company independent. But in almost every case they can earn more based upon the outcome. And as a result they do not necessarily have a financial interest which mirrors their client’s. Even in the relatively rare instance they receive a fixed fee for delivering or determining they cannot deliver a fairness opinion, failing to deliver such an opinion could have significant impact on whether they would ever receive such an assignment again.

But that is just the start of the conflicts of investment bankers. Bankers are not passively waiting by the telephone for the next assignment. They spend a lot of time coming up with ideas for deals and pitching them to current clients, former clients and prospective clients hoping to come up with a transaction that will earn them a fat fee. And if an idea gets them in the door, they frequently have ten more they can pitch if that one is rejected.

None of this is news or scandalous. Every CEO and CFO knows that despite any slogan about “putting clients first” investment bankers are always interested in earning a fee. Without meaning to denigrate either investment bankers or real estate agents, if you have ever bought or sold a house, did you really think your real estate agent was on any side but their own?

So bankers always have big financial interests. They aren’t always $4 billion, but even a multimillion fee should be enough to give any client pause as to potential interests.

That is why we do not put investment bankers in charge of a deal. Decision making is entrusted in a board of directors (whom we do usually expect to be disinterested—although according to Strine, the CEO of El Paso may have had some problems there as well; see Douglas Foshee’s response this morning).

Despite being in it for the bucks, bankers do have a lot of expertise and their advice can be valuable. And that is why public companies pay them huge fees. And it is the directors’ job to evaluate their advice under all of the circumstances, including the financial conflicts bankers have.

In the Kinder approach for El Paso, Goldman, working on a separate deal for El Paso, had a huge conflict. Yet if I were a director of El Paso, would I want them to quit on me when I received an unsolicited bid from Kinder Morgan—or even, as has been suggested in these pages, to switch sides? Absolutely not. As imperfect an advisor as they were, Goldman had a running head start. With a potential hostile multi-billion dollar deal just over horizon, would I want to cut loose any of my team?

And before we totally condemn Goldman, you should consider that Goldman has not had its day in court. Last week’s opinion related to a preliminary injunction motion. Not only was there no definitive finding of the facts, but the judge in such a motion is balancing factors, not reaching a final judgment.

The objective of El Paso in a situation like this is to ensure that the transaction is not held up. For example, frequently, it is equally effective to argue that even if everything the plaintiffs argue is true, plaintiffs will have an adequate remedy of damages. Although Strine didn’t fully buy this argument, despite all the defects, El Paso effectively won this case by being able to hold its shareholder vote and possibly close this deal. Negative findings about individuals or firms are collateral damage at this stage. If the case doesn’t settle, there will be ample chance to revisit these allegations in the case for damages.

Without being an apologist for Goldman, I think it seems unfair to judge it at this stage of the case. The Strine opinion is a powerful warning of how bankers should not conduct themselves—of this there can be no doubt.

But significant financial interest of investment bankers is inherent in the system and to expect otherwise is not fair. Moreover, although the opinion is an excellent object lesson, its procedural posture makes it less than an ideal vehicle for an indictment of any one firm or individual.

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